Volatility hedge funds operating in Asia have reported some spectacular losses since 2008. Despite this, there are still funds operating in the volatility arena. What strategies are working best and why is volatility so low?
Long volatility funds such as the Barracuda fund from Singapore-based Artradis, one of the biggest funds in Asia in 2008, were forced to close due to a lack of realised volatility in the post-financial crisis period from 2009 onwards and volatility has not come back according to hedge funds in the region.
Of seven volatility arbitrage funds in Asia, only three are in positive territory in the last 12 months. The best performer has been True Partner Fund (TPF), an Asia-focused global volatility arbitrage fund, which has brought home gains of 16.73 percent since inception in July 2011.
The fund’s investment strategy revolves around buying and selling relatively undervalued and overvalued options. “The last year has shown that our strategy has been able to generate decent and stable returns while markets were in risk-on and risk-off phases,” says Ralph van Put, chief executive of TPF in Hong Kong.
An undervalued option is determined by assessing levels of implied volatility compared with the fund’s benchmark or compared with realised levels and at-the-money options are primarily used rather than deep out-of-the-money options in order to avoid trading a tail event. Assets traded include equity indexes and single stocks using options and futures listed on exchanges in Asia, Europe and the US.
Its closest competitor is Pine River Capital’s Asia Master Fund, a convertible arbitrage fund based out of Hong Kong that reported returns of 3.92 percent over the last 12 months. One of the worst performers has been the India-focused Elara Absolute Return Fund with a – 12.59 percent return in the same period, according to Asia Hedge data.
Steve Diggle, founding partner at Artradis, closed down his Barracuda fund in February 2011 amid losses of $700 million stemming from a lack of volatility in the post-financial crisis period but in May that year he launched a Long Asian Volatility and Arbitrage Fund under his new investment vehicle Vulpes Investment Management. He says that the lack of volatility over several months has again proven to be a challenging trading environment. The fund declined 4.67 percent over the last year. “The strategy of being long volatility has been terrible as there have been no significant volatility events and the price of volatility has also remained stubbornly high,” he says.
The high cost can be partly attributed to the period before the financial crisis when few investors had bought downside protection and prices were cheap, which led to big losses for protection sellers. Diggle adds that the structure of the market has also fundamentally changed due to the lack of retail participation since 2009, which has made implied volatility expensive even against a lack of experienced volatility.
“In 2002 – 2008 when we ran Artradis there was a substantial retail component to the price of volatility from structured products. These were short volatility products and so they pushed down the price of volatility to abnormally cheap levels and then when they catastrophically failed in 2008, prices were at abnormally high levels. Since then retail investors have disappeared leaving behind a market that is entirely institutional and much thinner than previously.”
Paul John Andersson, head of pan-Asian equity derivative and convertible sales at Citi in Hong Kong, says that while equity structured product volumes since the financial crisis are down anywhere from 60 percent to 99 percent, in selected Asian markets the retail component is making a comeback and contributing to cheaper volatility. “In February and March Korea hit record highs in issuance of equity structured products. As an asset class volatility is still cheap in Asia,” he says.
That said, Scott Reinhart, head of the Hong Kong office at Pine River Capital, is surprised at the low levels of realised volatility. “Although our book is priced at a substantial discount, we are surprised realised volatility has not been higher given global market uncertainty,” he says.
Over the past 12 months as the euro crisis has rumbled on, volatility has been periodically high but not at extreme levels. Market participants say that central bank interventions such as quantitative easing and Europe’s long-term refinancing operations have artificially kept global volatility at low levels.